Recent Posts

At the quarter ending March 31, US annual GDP is estimated at
$15.3 trillion. At quarter-end, the S&P 500 Index
constituent companies had a combined market value of $12.7
trillion, or 83% of GDP. Many thanks to Ned Davis Research,
who computes this for us on a regular basis.

For US stock market investors, this 83% number is
significant. Let’s cite some references. At the bear
market bottom in March of 2009, this number was 47%. That is
about the same as the level that prevailed in the early 1990s.

At the 2007 stock market top, the ratio of S&P market cap to
GDP was about 98%. The all-time high was about 129% in
millennium year 2000 when the tech stock bubble was about to
burst.

Implied in this ratio is that it tells investors how the market
is valuing the profit share of these 500 companies in relation to
the economic output of the United States. A great deal of
the profits of American business are earned in the United
States. The rest is earned outside the US but is influenced
by the momentum of the US. Furthermore, those companies
with large overseas exposure are valued in the US capital
markets.

Using GDP as a reference, about half the business economy of the
US is privately owned. Many smaller business are in sub-S
form. The publicly traded and shareholder-owned companies
use the C-corp. or corporate form.

When we look at the profit share of the GDP going to US business,
we are seeing an aggregate number that includes both the publicly
traded companies and the privately owned companies. Right
now, that profit share is at the highest level we have seen in
many decades. Publicly traded and privately owned American
business is very profitable. Remember, we are looking at an
aggregate number. The government’s statisticians compute
these estimates from tax return information, thus the profit
series of the GDP accounting tends to be consistently calculated
and is a reliable indicator of the economically derived profits
of the US.

One can derive estimates of the earnings of the publicly traded
companies by using the GDP accounting for guidance. Note
that the reported earnings of companies differ from the profits
calculated by using the tax returns. But the trends in
those earnings and those profits run together over time.
Right now the trend is toward higher earnings, and that reflects
the large profit share that business is achieving from the GDP.

2012 earnings estimates for the S&P 500 seem to be centered
in the $100 to $105 range. That would put the stock market
at a valuation of about 13 times earnings. Many forecasters
are ratcheting down the growth rate of earnings for 2013.
We agree with that approach, since the profit share is so high
and is not likely to go much higher. In fact, there are
many estimates that suggest the profit share may actually start
to decline from its lofty level. We are among those who
think that will be the case.

So our assumptions are that the GDP continues to grow at a
moderate rate, say 5% nominally or about 2.5% real growth and
2.5% inflation. And we assume that the profit share from
the GDP stays high but not as high as the peak it achieved last
year. In two years these assumptions lead us to a US GDP of
about $16.5 trillion to $17 trillion.

The reason that the profit share will decline can be found in the
changes in the cost of labor. The annualized rate-of-change
to unit labor costs in the US was about plus 3% prior to the
Lehman-AIG meltdown and the recession. The recession took
this from plus 3% to minus 3%. This was the reason the
profit share was so high coming out of the recession. That
has now changed. The annualized unit labor costs
rate-of-change is now nearly back to its pre-recession plus 3%
level. (hat tip Steve Leuthold) Therefore the labor
share will eat into the profit share even as the GDP grows.

Using that GDP number, the growing labor share and assuming a
gradual change in the profit share, we can see S&P 500
earnings in 2014 of $115 to $120. If we use 13 times those
earnings as an assumed fair price of the S&P 500, we get a
1550-1600 price target for the S&P 500 index, and that would
equate with about an 85%-to-90% ratio for the market cap-to-GDP
ratio. This is neither overvalued nor undervalued. It
is more or less smack in the middle of the last twenty years of
US stock market history. Note that the stock market peak
was 1565 on the S&P 500 Index. By the method outlined
herein, we are still two years away from a new high.

Lots of assumptions go into this broadest of measures of the
valuation of the US stock market. Any number of things can
derail the outcome or make it better than this baseline.
But the baseline gives us some comfort. It suggests that
the S&P 500 Index can appreciate in price at the rate of
about 6%-to-7% per year and that it can pay out about another 2%
in dividends while that occurs. That total return is not
bad when compared with near-zero percent on cash equivalents and
with low single-digit interest rates on higher-grade
bonds.

At Cumberland, our equity accounts remain fully invested using
ETF strategies. Of course, we reserve the ability to change
this at any time. There are many potential shocks, and any
one of them could alter this sanguine view.